THE LM CURVE The LM curve in Figure 13.1 displays the alternative combinations of i and Y

at which the demand for money equals the supply. Figure 13.3 provides a derivation of the LM curve. The left panel shows a money demand curve

labeled M d and a money supply curve labeled M s . The horizontal axis measures the quantity of money and the vertical axis measures the interest rate. Note that the M s curve is vertical. This is so because the central bank can choose any money supply it wants, independent of the interest rate.

The actual value of the money supply chosen is M 0 . The money demand shows, for a fixed amount of wealth, how much people are willing to hold in money form, as opposed to interest-bearing assets. The money demand curve slopes downward, indicating that the higher the interest rate, the lower the quantity of money demanded.

The inverse relationship between the interest rate and quantity of

250 International Money and Finance

i) ate (

Interest r

i A A A'

M d' M d

Y A Y B Money supply (M)

M 0 M A'

Income (Y) Figure 13.3 Derivation of the LM curve.

increase, as seen in the shift from M 0 d to M d . Money demand increases because, at the higher level of income, people want to hold more money

to support the increased spending on transactions. Now let us consider why the LM curve has a positive slope. Suppose initially there is equilibrium at point A with the interest rate at i A and income at Y A in Figure 13.3 . If income increases from Y 0 A to Y B , money demand increases from M d to M d . If the interest rate remains at i A , there will be an excess demand for money. This is shown in the left panel of Figure 13.3 , as the quantity of money demanded is now M A 0

. With the higher income, money demand is given by M . At i , point A 0 A on the money demand curve is consistent with the higher quantity of money demanded, M A 0 . Since the money supply remains constant at M 0 , there will be an excess demand for money given by M A 0 2M 0 . The attempt to increase money balances above the quantity of money outstanding will

The IS-LM-BP Approach 251

equilibrium. This requires a higher Y or lower i, or both, so the LM curve will shift right. Similarly, a decrease in the money supply will tend to raise

i and lower Y, and the LM curve will shift to the left.

THE BP CURVE The final curve portrayed in Figure 13.1 is the BP curve. The BP curve

gives the combinations of i and Y that yield balance of payments equilibrium. The BP curve is drawn for a given domestic price level, a given exchange rate, and a given net foreign debt. Equilibrium occurs when the current account surplus is equal to the capital account deficit. Recall from Chapter 3 that if there is a current account deficit, then it has to be financed by a capital account surplus.

Figure 13.4 illustrates the derivation of the BP curve. The lower panel of the figure shows a CS line, representing the current account surplus, and a CD line, representing the capital account deficit. Realistically, the current account surplus may be negative, which would indicate a deficit. Similarly, the capital account deficit may be negative, indicating a surplus. The CS line is downward sloping because as income increases, domestic imports increase and the current account surplus falls. The capital account is assumed to be a function of the interest rate and is, therefore, independent of income and a horizontal line.

Equilibrium occurs when the current account surplus equals the capital account deficit, so that the official settlements balance of payments is zero. Initially, equilibrium occurs at point A with income level Y A and interest rate i A . If the interest rate increases, then domestic financial assets are more attractive to foreign buyers and the capital account deficit falls to CD 0 . At the old income level Y A , the current account surplus will exceed the capital account deficit, and income must increase to Y B to provide a new equilibrium at point B. Points A and B on the BP curve in Figure 13.4 illustrate that, as i increases, Y must also increase to maintain equilibrium. Only an upward-sloping BP curve will provide combinations of i and Y consistent with equilibrium.

252 International Money and Finance

Interest r

CS CD plus =

A CD

CD' Current account sur Capital account deficit =

0 Y A Y B CS

Income (Y )

Figure 13.4 Derivation of the BP curve.

point e is the equilibrium point that occurs at the equilibrium interest rate

i e and the equilibrium income level Y e . Until some change occurs that shifts one of the curves, the IS-LM-BP equilibrium will be consistent with all goods produced being sold, money demand equal to money supply, and

a current account surplus equal to a capital account deficit that yields a zero balance on the official settlements account.

SHIFTING THE BP CURVE In deriving the BP curve, we assumed that higher interest rates in the

domestic economy would attract foreign investors and decrease the capital

The IS-LM-BP Approach 253

Interest Rate

BP Upward-sloping

BP Horizontal

Y 1 Real Output Figure 13.5 The slope of the BP curve.

the BP curve will become close to vertical. Figure 13.5 illustrates a per- fectly horizontal BP curve, and an upward-sloping BP curve.

It is also important to realize that the BP curve can shift whether it is upward sloping or horizontal. For example, a changing foreign perception of the substitutability shifts the BP curve. This is an intercept change, and thus the entire schedule shifts. For example, in Figure 13.6 one can see how an increase in the perception of riskiness of a country’s assets causes the BP curve to shift upward. Thus, interest rates are not equal across countries even with perfect capital mobility. For example, Indonesia may have a positive risk premium, so that investors demand a certain added premium for financing Indonesia’s trade deficits. However, as long as that particular risk premium is paid, investors are willing to finance the trade deficit.

THE LM CURVE The LM curve in Figure 13.1 displays the alternative combinations of i and Y